What is interest rate averaging?

Interest rate average (IRA) is a risk management strategy used to hedge against interest rate fluctuations. IRA effectively splits your mortgage into multiple portions and allocates each portion to a different interest rates and durations. It’s an extremely valuable tool for first home buyers. However it works best when interest rates are rising and is less effective when interest rates are falling. IFA is a risk management tool and therefore you have to take both the pros and cons if you decide to employ this strategy. This is best highlighted using an example: 

Please note this is a hypothetical and not the real interest rates. We will also assume that the mortgage is going to be interest-only:

 Mortgage amount: $600,000 
1-year fixed interest rate = 6.5% 
2-year fixed interest rate = 6.6% 
3-year fixed interest rate = 6.7% 
4-year fixed interest rate = 6.8% 
5-year fixed interest rate = 6.9% 
Floating interest rate = 7.5% 

 An example of interest rate averaging will be the following: 

• $200,000 - 1-year fixed rate at 6.5% 

• $200,000 - 2-year fixed rate at 6.6% 

• $200,000 - 3-year fixed rate at 6.7% 

 
After one-year, you will have to look at re-fixing or re-structuring the expired 1-year rate. 

Scenario One: 
All interest rates have increased by 2% i.e. the new 1-year rate is 8.5%, 2-year rate is 8.6% etc.  This means that only $200,000 is exposed to the higher rates. The remaining $400,000 is on 6.6% and 6.7% respectively ($200,000 each). Interest rate averaging has just saved you from a drastic increase in mortgage repayments by only exposing 1/3 of the mortgage to higher rates.  

Scenario Two:  
All interest rates have dropped by 2% i.e. the new 1-year rate is 4.5%, 2-year rate is 4.6% etc. This means that only $200,000 will get the benefit of lower rates. The remaining $400,000 is on 6.6% and 6.7% respectively ($200,000 each). In this situation, only 1/3 of your mortgage will get the benefits of lower interest rates. The remaining $400,000 will be on higher rates. If you wanted to re-structure or re-finance the remaining $400,000  to the new rates - a break-fee will apply. 

 
However, note that IFA would have given a greater benefit if: 

• Under scenario one, if the 1-year interest rate split was given a bigger portion - for example $300,000 allocated to 1-year rate and the 2-year and 3-year rate got allocations of $150,000.  
  

• Under scenario two, we split two-ways, instead of three-ways as half the mortgage would have benefited from lower interest rates rather then 1/3. 

 
Determining how you will split your mortgage is the key and if you were to use a strategy like IRA - it’s best to deal with a Mortgage Adviser (aka Mortgage Broker). 

 
Moral of the story: 
While IRA is an effective tool - it’s more handy when interest rates rise. Even when interest rates are decreasing - you will still benefit from this strategy depending on how you split your mortgage. Feel free to talk to us before employing a strategy such as IRA. Knowledgeable Mortgage Brokers have access to industry information regarding where interest rates could be heading.